The Confident Investor

If you have read this site for long, read my book, The Confident Investor, or even followed me on Twitter then you have quickly learned that I don’t recommend mutual funds to most investors. I feel that an investor can do better by having 20-40% of the portfolio in Index Funds (or Index ETFs) and then the balance in high quality stocks such as the ones on my Watch List.  I further suggest that you build your net worth in those great stocks by using my GOPM methodology (Grow on Other People’s Money). It is the easiest and most effective way that I have found at increasing the size of your portfolio.

However, I frequently am asked by new investors about mutual funds and how they work. So I thought a short explanation was relevant. If you are an experienced investor then I am sorry if this article is too basic for you – please pass it along to a new investor that you may be mentoring.

A mutual fund is a professionally-managed pool of money that invests in some combination of stocks, bonds, or cash for the benefit of the mutual fund investors. In a mutual fund, you share the increases or decreases in the value of the fund. You do not officially own a share of the fund, such as in a company, but the distinction is irrelevant for an individual investor.

A mutual fund spreads your investment dollars around better than you might be able to do by yourself. This diversification tends to reduce your risk of losing money as well as making money. Diversification usually results in less sudden changes in value, as when some investments are doing poorly, others may be doing well. The reverse is true as well, when one mutual fund holding is doing well it will be tempered by other poor performers in the fund.

A mutual fund’s investment managers are trained to look for the best possible returns that are consistent with the fund’s strategies and goals. You can almost take it for granted that your mutual fund investment will provide you with the services of a professional money manager. You are in effect betting that the manager will make competent decisions for your investment dollar. In the majority of cases, he is hired or fired on the basis of the whims of the investment firm for which he works. He is rarely subject to customer reviews. It is very seldom the case that you can vote for him being fired, as you could potentially do with the CEO of one of your companies.

Combining your money with other investors creates collective buying power. As a group, mutual fund investors can buy a wide selection of investments. So, rather than just buy one car manufacturer or one bank, they have the funds to buy into ten companies that are similar. This allows you to take advantage of industry trends without relying of the success of one single company.

The size of a fund can be its downfall if it specializes in just one industry segment. If there are not enough excellent companies, then the manager may have to buy into lower quality companies. This strategy potentially invests in too many sub-par companies. The lowering of standards may lead to reduced returns.

You can learn more about the stock market and, more importantly, how to make money in the stock market by buying my book. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in ebook formats for Nook, Kindle, and iPad.

The Wall Street Journal Opinion page has an interesting article. The author, Rich Karlgaard of Forbes magazine, claims that our current rally of stocks is not a true rally. He does this by comparing the growth of various stock market “rallies” with the growth in price in high-value commodities. For instance:

• The current rally has the S&P 500 up 124% over the past four years but gold is up 88%, oil 106% and silver 167%.
• In the 1974-1980 rally, the S&P 500 was a gain of 103%. But over those six years gold rose in value by 182%, oil by 270% and silver by 340%.
• August 1982 to January 2000 boom, during which the S&P 500 soared 1,194% while gold dropped in value by 35%, oil by 23%, and silver by 17%. Stocks way up. Commodities down.

Mr. Karlgaard’s opinion is the boom of 1982-2000 was a true stock rally while the others were simply a market reaction to the politics and economics of the time. He opines that since commodities went up then the stock market had to go up. All of the investment categories rose together so therefore it wasn’t a true rally.

I will make a couple of points.

• A couple of data points do not make a trend.
• Investopedia and Wikipedia don’t define a rally as only being a rally when it is exclusive.
• It probably doesn’t matter. While I don’t comment on commodities trading on this site, I understand why some investors choose those markets and I wish them well. The performance of the commodities markets really doesn’t matter to me except as they effect the performance of my stock holdings due to the cost of raw goods.
• Regardless of the reason why a market becomes a bull market, it is the responsibility of investors to take advantage of the rally and maximize the return.

The system that I propose in my book, The Confident Investor, does great in a rally. Interestingly, the system has a higher increase in return in bad market times but that is simply because the standard of success (Buy-and-Hold) is so low during bad market times. To use a sports metaphor, it is easy to look like Michael Jordan on an 8 foot rim! Although perhaps I shouldn’t sell myself short – during a rally it is easy to make money (a blind squirrel can find nuts and get fat in a cashew factory) but making money in a turbulent market as I show in The Confident Investor is a real feat.